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Should you get an inflation-adjusted annuity?

USATODAY
12:31 p.m. EDT October 21, 2013

An inflation-adjusted annuity aims to solve the problem by giving you an automatic cost-of-living increase every year. But the cost is steep.

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Story Highlights

Rule of thumb for retirement savings: Take 4% the first year, increase for inflation

Inflation-adjusted annuities can take some of the guesswork out of retirement — at a price

Most people still have nightmares about math word problems: "If Nate has 37 red gumdrops and Hope has 43 blue feathers, what time will their train reach Altoona?"

If you have a 401(k) plan, you're being asked to solve a similarly impossible problem: "Assume that R is the amount of money you'll need to retire, X is the number of years you'll live, Y is your rate of return, and Z is the rate of inflation. You have no idea what X,Y, or Z is. Solve for R."

One solution is an inflation-adjusted annuity, which promises to pay you a sum that will rise with the cost of living every year until you die, much as Social Security does. Should you try one? Only if you expect to live long — and even then, you'd be better off waiting until interest rates rise.

The rule of thumb with 401(k) withdrawals is to start by taking out 4% of your portfolio the first year, and adjusting that amount upward for inflation each year. Most times, it's too conservative: You'd need a $1.25 million portfolio to get an initial $50,000 annual withdrawal. But when the first few years are down years in the stock market, your withdrawals can simply aggravate your losses and increase the chance you'll run out of money.

Because the stock market is unpredictable, to say the least, some people use an immediate annuity to smooth out some of the bumps in a portfolio. An immediate annuity is a contract between you and an insurance company. You pay the company a lump sum, and they agree to pay you a set amount per month for the rest of your life. If you live to 120, you win. If you join the Choir Invisible the year after signing the contract, you lose, and the annuity company pockets your investment.

The payout is based primarily on an interest rate — what the company expects to earn on your lump sum. As a simple example, suppose you want to invest $100,000. According to Immediateannuity.com, a 65-year-old man could get $548 a month for life — a 6.58% payout rate.

The 30-year Treasury bond yields about 3%, and insurance companies are not magic yield-making wizards. Some of the extra yield comes from the money left on the table by annuitants who have gone to the great field office in the sky.

The rest comes from the insurance company's own investments, which is why it's good to choose a financially strong annuity company. You want a company that can still pay, even during economically stressful times. States do have guaranty associations backing annuity policies, typically to at least $100,000, but it's best to avoid shaky companies entirely.

While the annuity's payout is decent, it's fixed. Let's assume that inflation averages 3% — the average inflation rate since 1926, according to Morningstar. The effects of inflation are cumulative: After 30 years of 3% inflation, your $548 will have the buying power of $220. Unless you plan to live on toasted plaster, you'll have to find a way to offset inflation, and a fixed annuity won't provide that.

An inflation-adjusted annuity aims to solve the problem by giving you an automatic cost-of-living increase every year. But the cost is steep. A $100,000 inflation-adjusted annuity policy from Principal Life Insurance offers a $379 monthly payout for a 65-year-old man; American General offers a $363 monthly check. At 3% inflation, you'd have to wait 15 years before you'd equal the payout from an immediate annuity without inflation protection.

Incidentally, the average Social Security payment, which bears strong similarities to an inflation-adjusted annuity, is $1,234. An inflation-adjusted annuity yielding the same amount would cost a 65-year-old $325,877 to $348,600, according to Vanguard. That's without benefits to survivors or disability benefits, which Social Security also provides.

An immediate annuity can have a place in your retirement portfolio, particularly if you feel you need to have at least one stream of income you can count on. But because interest rates are so low, you should wait until rates rise again before purchasing an annuity. Your money will go much further when the 10-year Treasury note, now yielding about 1.8%, rises to more normal levels. The average since the 10-year was introduced is 6.6%.

If you're willing to take more risk, however, you may be able to get better income from dividend-paying stocks. Although a dividend hike is never certain, a good number of stocks have a long record of increasing dividends over time. For example, 1,000 shares of Exxon Mobil paid $1,280 in dividends in 2007. The same 1,000 shares have paid $1,610 in dividends the past 12 months.

You can see a list of companies that have raised their dividends every year for a decade through Mergent's Handbook of Dividend Achievers at www.mergent.com. Vanguard's Dividend Appreciation ETF (ticker: VIG) invests in the Dividend Achievers; currently, it has a yield of 2.08%.

Nothing's easy about figuring out retirement. If you really must have guaranteed income, consider an immediate annuity — eventually. Otherwise, you'll probably be better with a mix of income investments, especially those that can throw off more income over time.